The drop in 10-year Treasury
yields last week to the lowest level since October has defied nearly all expectations, making investors nervous and a touch giddy as they try to plot the path forward. But Mohamed El-Erian says the factors driving interest rates down have built-in self-correction mechanisms that should eventually push yields higher.

In a commentary in the Financial Times Monday, the Allianz chief economic adviser and former Pimco CEO plays Wall Street\’s favorite parlor game: explaining the Treasury rally. Here are El-Erian\’s three reasons:

Bloomberg

Mohamed El-Erian

1) Concerns slow growth in the U.S. and Europe that have led to fears about consumer and wholesale prices rising too tepidly, or a slide into \”lowflation\” in his terminology.

2) Central banks that want to support growth as best they can, which means continuing to adopt accommodative monetary policies. The European Central Bank is expected to enact easing measures next month, and the U.S. Federal Reserve continues to reassure markets that it won\’t tighten policy too soon.

3) Technical positioning of investors exacerbated the yield movements. Traders shorted the market thinking yields would rise, but were caught on the wrong side of the trade. That led to \”market stops, forcing them to buy bonds to limit their mounting losses.\”

But each of these factors theoretically has a self-correcting mechanism built into it, El-Erian writes:

\”In theory, there is little to worry about as lower interest rates should be self-correcting on all three counts. By reducing mortgage rates, they increase house affordability and, for existing homeowners, the incentive to refinance mortgages – both of which support home prices and housing activity. They also push investors out of bond holdings and into riskier assets.

\”Indeed, this is the main objective of the “unconventional policies” pursued by major central banks, in the hope that the resulting price surge in risky assets makes households and businesses feel better, encouraging greater consumption and higher investment (via energized “animal spirits”). Finally, offside traders’ positions get cleaned up as more are stopped out.\”

Nonetheless, it may not play out that smoothly, he says, as concerns about economic growth could lead investors to exit stocks, credit, emerging markets, and other assets that depend on expansion of the economy. There\’s a lot of noise that could obscure market movement, but the clearest path toward movement higher in rates is an acceleration in growth.

The explanation by El-Erian, who departed Pimco earlier this year, shares some similarities with that of Bill Gross, the money management firm\’s chief investment officer. Gross told MarketWatch last week that the rally reflects lower trend economic growth across the globe, which is likely to keep central banks more accommodative than they have been in the past. Gross takes it a step further, tying the rally to the theory that central bank lending rates will peak lower than in past economic cycles. Gross also told Barron\’s that technical positioning played a role as well.

Others are bringing those views together too. Here\’s J.P. Morgan\’s European equity strategy team, led by Mislav Matejka, in a Monday note.

\”The recent bond rally is clearly partly due to the loss of US growth momentum in Q1, but our fixed income strategists suggest that it was also due to expectations of a lower neutral Fed funds rate, declining duration supply and subdued inflation.

Given that, the J.P. Morgan strategists say \”We don’t think that the recent bond rally should be interpreted as a negative for equities.\”

But not everyone sees a slow-growth world that will remain awash in easy money policies. Zach Pandl, portfolio manager and strategist at Columbia Management, said in a report Friday that signs of increasing growth and dissipating after-effects from the financial crisis mean the peak fed funds rate is likely closer to 3.75% or 4%.

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